Smaller is Beautiful

Mutual fund investors made one thing clear in the first quarter of 2011: They put their trust in small-cap and mid-cap strategies to power economic growth and provide stability. Small-cap growth funds enjoyed a 9.2% run, while mid-cap growth funds rose 7.8%. Small-cap and mid-cap blend funds were both ahead 7.9%.

"People thought large caps would come back and beat small caps," says Russ Kinnel, director of mutual fund research at Morningstar. "By a lot of measures blue-chip stocks are cheap, but that does not always translate to a single quarter's solid performance."

The large-cap blend group lagged its smaller siblings with a respectable gain of 5.6%. "That is still good, when you consider all of the bad things that happened in the first quarter," Kinnel says.

It is no surprise small- and mid-cap funds outperformed, says Jeff Tjornehoj, a mutual fund analyst at Lipper. "In a recovering economy, they are perceived as more flexible and dynamic," he says.

ANXIETY EVERYWHERE

The uprisings in the Middle East and North Africa, as well as the disasters that have pummeled Japan, did make many mutual fund investors jittery. Japanese stock funds were the worst performer, sliding 5.1%, Kinnel says. The Pacific-Asia ex-Japan category gave back 1.6%, and diversified Pacific-Asia funds were down 1.1%.

Following the Japanese disaster, "there was a concerted effort by interested investors to act quickly on that, to buy good Japanese stocks at a 10% discount," in correlation to the Nikkei's one-day dip of 10.4% immediately after the quake, Tjornehoj says. However, the gains did not help Japanese funds erase previous losses, and they finished the first quarter in negative territory.

Long government bond funds performed poorly as well, losing 1.5%. Kinnel says this stemmed partly from oil price inflation. "Also, people are continuing to worry about potential rate hikes and rising interest rates in general," he says.

American investors had another looming issue to contend with-the fragile state of the municipal bond market. Yet widespread predictions of defaults by public debt issuers, from states to utility authorities, were not credible, Kinnel says.

Still, that did not stop municipal mutual funds from suffering $19.4 billion in net outflows in the first quarter. However, the amount has slowed every month since the end of 2010.

Overall, the fund flow trend was also mixed. Mutual funds (excluding money market funds) collected $27 billion in March, down from about $27.9 billion in February, according to Morningstar. Domestic stock funds had outflows of $934 million in March, after pulling in roughly $26.1 billion in January and February combined.

Kinnel says he expects the fund flow trends to continue, especially for municipal bond funds. "I wouldn't be surprised to see investors go into taxable and out of tax-free funds," he says.

TROUBLE AHEAD

Of the 5,721 equity funds that Lipper tracks, about 70% were up in March, a dip compared with the 90% of funds that did well during the entire quarter. Given the growing European debt crisis, the slide in March is a worthy indicator of what might unfold in the second quarter, Tjornehoj says.